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The Impact of OTC Derivatives Industry Change on Buy-Side Operations

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September 29, 2009
©2009 JPMorgan Chase & Co. All rights reserved. JPMorgan Chase Bank, N.A.

Agenda
• • • • • • Background Central Counterparty Clearing Central Settlement Derivatives Collateral Management Credit Derivatives Standardisation Trade Reporting & Transparency

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©2009 JPMorgan Chase & Co. All rights reserved. JPMorgan Chase Bank, N.A.

A. JPMorgan Chase Bank. .Background September 29. N. All rights reserved. 2009 ©2009 JPMorgan Chase & Co.

JPMorgan Chase Bank. All rights reserved. excludes OMG dealer-specific and Fed Letter signatory-specific commitments „ Includes ongoing commitments set-out in the 31 October 2008 letter. and 94% T+2 matching for electronically eligible transactions (31 Dec) „ Latest date for Buy-side access to CDS Clearing (15 Dec) Credit 30 Nov 2009 „ All eligible credit derivatives backloaded onto DTCC TIW „ 96% of settlements on DTCC-eligible trades to be centrally settled via TIW / CLS Jun ‘09 Jul ‘09 Aug ‘09 Sep ‘09 Oct ‘09 Nov ‘09 Dec ‘09 Jan ‘10 Feb ‘10 Mar ‘10 Apr ‘10 May ‘10 Jun ‘10 Jul ‘10 Equity 31 Dec 2009 „ 50% of total volume able to be electronically matched 30 Sep 2010 „ Universal recording of equity trades in a centralised regulated repository: represents 31 Jul 10 for signatories + 60 days** 30 Jun 2009 „ Plan for rollout of automated allocation functionality* 30 Sep 2009 „ Strategic road map for cash flow recs. implementation schedule to follow Collateral 31 Oct 2009 „ Feasibility study on market-wide portfolio reconciliation (undertaken by the ISDA Collateral Committee) 4 ©2009 JPMorgan Chase & Co.2 June 2009 ‘Fed Letter’ 30 Jun 2009 „ Analysis complete for buy-side access to CDS clearing „ Agreed plan for one-step novation consent = confirmation 31 Aug 2009 „ 90% of settlements on DTCC-eligible trades to be centrally settled via TIW / CLS Summary of buy-side commitments General Notes „ Reflects ‘whole industry’ commitments only. including any client-specific duties or obligations *Subject to regulatory approval of MarkitSERV (now obtained) ** Strongly encouraged 17 Sep 2009 „ Weekly recording of CDS trades in a centralised regulated repository: represents 17 July for Signatories + 60 days** 30 Sep 2009 „ All eligible new trades & novations must be confirmed on DTCC or other electronic platform Dec 2009 „ 90% T+0 submission. these commitments are subject to applicable fiduciary responsibilities. . N.A. central netting & settlement 30 Nov 2009 „ Plan for rollout of electronic novation consent * 28 Feb 2010 „ Universal recording of IRD trades in a centralised regulated repository: represents 31 Dec ‘09 for signatories + 60 days** Rates 30 Sep 2009 „ Marketwide solution for improved resolution of disputed margin calls (DR protocol). excludes collateral-related commitments „ For asset management firms.

also public access to aggregated data Also: „ „ „ „ CCP clearing in Europe by 31 July ’09. payment automation and collateral management processes „ Central Data Repositories – to improve higher capital & margin requirements for nonstandardised derivatives „ More Transparency – Access by all relevant federal transparency and improve operational efficiency (e.. „ Trading – requires standardised OTC derivatives to be traded on a regulated (CFTC.A. SEC) exchange or alternative swap execution facility (‘ASEF’) „ Encourage Greater Standardisation – through in broader take-up of standard contracts.OTC Derivatives Markets Act 2009 11 August 2009 Key Proposals „ Central Clearing – requires standardised OTC EC – Communication on Derivatives Markets 3 July 2009 Key Proposals „ Further Standardisation – incentivise investment derivatives to be centrally cleared by a regulated (CFTC. electronic confirmation services. ..g. SEC) clearing organisation. DTCC’s Trade Information Warehouse). central storage.Legislative change is coming US . through regulatory capital rules) „ Move to Public Trading Venues – the EC will Extended regulation of dealers and major participants Robust and comprehensive regulation Position limits Protection of unsophisticated investors examine how to arrive at a more transparent and efficient trading process for OTC derivatives 5 ©2009 JPMorgan Chase & Co. the EU will act upon the findings of a CESR review „ Central Clearing – industry commitment to achieve regulators to the specific OTC transactions and positions of participants.g. JPMorgan Chase Bank. N. further incentivise the broader use of CCPs (e. All rights reserved.

JPMorgan Chase Bank.Central Counterparty Clearing September 29. 2009 ©2009 JPMorgan Chase & Co. All rights reserved.A. . N.

access will be via a designated derivatives clearing member (DCM. N. JPMorgan Chase Bank. instead. or clearing broker) Trade Execution Trade Cleared Party A Party B Trade Cleared Party A CCP Party B Counterparty Risk Mutualised Market Risk Flat Counterparty Risk Mutualised 7 ©2009 JPMorgan Chase & Co. even if the party to the offsetting trade defaults ‘Initial’ and ‘variation’ margin is posted with the CCP by each party Dealer to dealer clearing has been operational for nearly 10 years for rates and six months for credit Buy-side firms are not generally expected to become direct members of CCPs themselves. All rights reserved.What is central counterparty clearing? • • • • • Trade execution remains bilateral. once the trade is agreed. the CCP guarantees financial performance. it is transferred (novated) to a central counterparty (CCP) The CCP intermediates the trade. .A. replacing original counterparty risk.

TIW. 10 yr tenors Latest 4 series SN constituents Key Infrastructure Full Support of DTCC. 5.A. 14 currencies Further products under development MarkitWire $5bil minimum capital Swap portfolio of $1trn+ ‘A’ credit rating or above Required to bid in auctions Membership requirements $5bil of Tier 1 capital. CMDX Planned connectivity to DTCC EUREX SwapClear ISDA language within ISDA Annex standard Clearing Conditions EUR 1bil of Tier 1 capital or higher Min $50m security deposit. XO. . but industry standards and operating models starting to take shape • June Fed Letter commitment to buy-side clearing of CDS by mid-Dec ’09. XO iTraxx HVOL. HY. ICE Clear) Contract type Full ISDA CME Future on commodity under Clearing Agreement referencing ISDA Language $300mn of ANC/Tier 1 capital $5m CDS security deposit. HY. N. XO Latest 4 series Single names in testing 30-40 SN iTraxx constituents OIS 8 ©2009 JPMorgan Chase & Co.CCP models are still evolving Industry Industry Status Status / / Plans Plans • Rapidly evolving CCP picture across credit and rates. HY. auctions TIW bronze entry. HVOL. 7. HVOL. with fall-back to wider fund Stress-based IM Credit CDX IG. risk adjusted FTD and liquidity based IM EU Domicile Credit iTraxx HVOL. iTraxx HVOL. A Credit $50m CDS security deposit Var/Monte Carlo-based IM Operational competence Product Scope Credit CDX IG. JPMorgan Chase Bank. Icelink(T Zero). XO 3. XO Latest 3 series Rates Vanilla IRS up to 30 years Euribor/Libor. Clearport. All rights reserved. rates client clearing in 2009 is also a focus area • Individual broker firms are designing and planning their clearing member offerings Example Offerings: ICE (ICE Trust.

What might the buy-side model look like? Example workflow for credit Execution 1 2 Client 6 3 1 Dealer 2 6 3 Agreement of Trade Detail 4 Acceptance for Clearing Middleware 5 Legal Confirmation 6a 6 4 5 Submission to TIW DCM 7 CCP 6 6a Transaction and Position Reporting TIW 8 7 Settlement CLS (fees. DCM).A. coupons) CCP (margin) 8 Trade executed Dealer submits trade executed bilaterally to middleware for matching „ CCP is specified. All rights reserved. and between DCM and client Legend: Initial trade agreement and acceptance Trade notification (and enrichment) Key Considerations • Agreed trade between client and dealer should be a legally binding bilateral trade until cleared (potentially only for minutes but that state should exist) • If trades not accepted for clearing then fallback to being bilateral • If a trade is not affirmed then it cannot process through to clearing but is still legally binding between client and dealer based on execution • Trades submitted on individual (gross) basis. but assume they could have added these on initial submissions Middleware submits all trades on an individual (gross) basis to TIW as matched trades Settlement of fees and coupons via CLS. JPMorgan Chase Bank. with all trades „ DCM v client „ DCM v CCP (DCM client account) „ Dealer v CCP (dealer house account trade) DCM sends a message back to middleware with their references on the booked trades „ Either the dealer or client may also add IDs for submission to TIW. middleware submits the trades to the CCP for clearing „ CCP determines if the trades are accepted for clearing and sends a message back to middleware If the trades are cleared middleware sends a message to all parties. this is a matching field Client Agrees trade in middleware (at this point legally binding bilateral trade) „ Client specifies the DCM. dealer. this is not a matching field „ Client specifies allocations if applicable Middleware will send a notification of the matched trades to DCM for acceptance „ DCM completes limit/eligibility checks and accepts/rejects trade for clearing Once all three parties have affirmed (client. N. . margin settles via CCP and clearing members. strategic goal to have affirmation = confirmation within middleware 9 ©2009 JPMorgan Chase & Co. netting/compression process to be completed separately from clearing submission • Confirmation process unchanged initially.

All rights reserved.. coupon and fee settlements + daily margin requirement) Central settlement via CLS remains a goal for the buy side Other „ „ (Credit) Processing impact of credit events (Rates) Impact of novation event: requires a ‘declear and reclear’ process 10 ©2009 JPMorgan Chase & Co.g.g. MarkitWire.. N. or to executing broker and subsequent amendment to DCM? Timeliness of capture and early allocation (no clearing until allocations completed) May need subsequent capture of clearing ID FUNCTION Valuation „ „ „ Move to CCP’s as source of MTM valuations on cleared trades Need to review and approve CCP valuation methodology by pricing committees? Comparison of CCP valuation to independent source Reporting „ Enhanced risk reporting – CCP vs non-CCP positions Confirmation „ „ „ „ „ „ CCP becomes a matching field. clearing agreements.. . management of exceptions Access to ‘Middleware workflow’ required (e. JPMorgan Chase Bank.e. compensation agreements) Settlement „ „ Potential netting of daily cash flows to a single payment (i. DCM to be determined/specified More aggressive timing (e.A. ISDA appendix. 30 mins following execution) Tracking of DCM and CCP acceptance..g.How are buy-side process flows impacted? FUNCTION Trade Capture „ „ „ „ Up-front capture of specified CCP as agreed with executing broker ‘Give-up’ to DCM – initial booking straight to DCM. ICE Link) Maintenance of CCP-related static data in middleware Backloading requirement Counterparty Reconciliation „ „ Reconciliation of ‘cleared’ positions to DCM and non-cleared positions to executing broker Reconciliation of eligible positions to DTCC’s TIW Collateral Management „ „ „ Management of initial margin and daily variation margin to & from DCMs Verification of margin amounts per CCP algorithm and clearing agreement with DCM – no recourse to challenge Additional documentation (e.

CCP checklist 9 Choice of CCP – Are you making an assessment of the various CCP provider offerings? 9 Selection of Clearing Broker(s) – Are you reviewing clearing broker capabilities? Who would be your backup broker? 9 Timeline – Are you aiming for implementation in 2009? 9 Middleware – Are you live on the necessary workflow tools? 9 Process Flows – Do your current process flows support the timeliness objectives for clearing? 9 Margin – Have you considered the impact on your collateral requirements and process? 9 Backloading – What is your existing population of eligible deals to be backloaded? 9 Additional Legals – What additional legal documentation will you need to review and sign? 9 Administrator / Outsourced Provider – Is your service provider ready to support procedural changes? 9 Commercials – Are you clear on the costs of Clearing? What rate of interest will your DCM pay on margin posted to them? 11 ©2009 JPMorgan Chase & Co.A. . All rights reserved. N. JPMorgan Chase Bank.

JPMorgan Chase Bank. N. .A. 2009 ©2009 JPMorgan Chase & Co.Central Settlement September 29. All rights reserved.

don’t pay” – settlement depends upon timely completion of confirmation process (by 12:00 ET on VD-1) • Settlement netting by fund. legal entity and position ‘certainty’ status 13 ©2009 JPMorgan Chase & Co. All rights reserved. to ‘automatic’ settlement messaging via TIW and CLS • “No match. currency and value date • ‘Bifurcation’ of settlement processing based on instrument.Implementation of CDS central settlement Industry Status Status / / Plans Plans Industry • Dealer community live on central settlement via DTCC TIW and CLS since Q4 2007 • Initial buy-side firms went live in May/June this year • Broader industry commitments for buy-side roll-out in 2009 have not been achieved – revised targets under consideration Benefits Benefits • ‘Certainty of settlement’ – elimination of unexpected cash breaks and compensation claims • Operational risk reduction through move from bilateral settlement to automated netted settlement • Reduction in need for presettlement matching across multiple counterparties – DTCC cash flow record is ‘golden’ • Netting across FX and OTC has the potential to reduce funding costs Impact Impact • Move from bilateral (SWIFT. N. fax.A. counterparty. file) instruction to custodian/PB. JPMorgan Chase Bank. . currency.

. N. CLS. All rights reserved. custodian. JPMorgan Chase Bank. counterparty)? 9 Outsourced Provider – Is your provider ready to support the necessary changes to their OTC settlement process flows? 14 ©2009 JPMorgan Chase & Co.Central settlement checklist 9 Process Reengineering – Have you adapted your settlement processes and controls? 9 Confirmation Dependency – Can you meet the necessary confirmation deadlines for all eligible events? 9 Backloading – Have you backloaded all of your eligible positions into DTCC TIW (30 Nov 2009 target) 9 CLS Settlement Member – Do you have access to a CLS settlement provider (direct.A. third party)? 9 Custodian Readiness – Have your custodians implemented central settlement capability? 9 Onboarding Notification – Have you notified DTCC of your implementation plans? 9 Implementation Window – Have you considered the implementation ‘blackout’ periods around the quarterly rolls? 9 Legal Documentation – Have you signed the incremental documentation required by DTCC and your custodian(s)? 9 User Acceptance Testing – have you planned UAT with all participants (custodian.

Derivatives Collateral Management September 29. 2009 ©2009 JPMorgan Chase & Co. N. All rights reserved.A. . JPMorgan Chase Bank.

create more segregated accounts at custodians. set up escalation timelines and procedures • Portfolio Reconciliation – Will set out best practice guidelines around frequency.A. and more infrastructure links between the sell side and custodians • Best practice guidelines will tighten up procedures around grey areas in the market. calculations. N. . more tri-party agreements.Developments in derivatives collateral management Industry Industry Status Status / / Plans Plans • ISDA Dispute Resolution Protocol due on 30 September 2009 • ISDA Portfolio Reconciliation Best Practice due on 31 October 2009 • ISDA Hedge Fund Independent Amounts white paper due to be published 31 October 2009 • ISDA Best Practice Guide for Collateral Management due in June 2010 • Development of new CCPs will create a more complex collateral management landscape for both buy side and sell side Benefits Benefits • Dispute Resolution – Will set out roles and obligations during a dispute. and ways to implement • Best Practice Collateral Guidelines – Will set out an industry best practice around valuations. timelines and escalations during a reconciliation • Independent Amounts – Will set out possible solutions to issue of collateral held as an independent amount. All rights reserved. and provide more guidance on standard practice and electives 16 ©2009 JPMorgan Chase & Co. messaging and settlements Impact Impact • Reconciliations and dispute resolution will create tighter standards of performance and remediation that will require training and infrastructure in order to comply • Independent amount solutions may necessitate the bifurcation of initial and variation margin. JPMorgan Chase Bank.

so some form of mapping change will need to be implemented once confirmed. although using them as a yardstick to view appropriateness is useful. and intended for large sell-side firms. and that you are in regular discussion to ensure adherence to those changes. and SOPs (standard operating procedures) updated. are still being worked through. N. JPMorgan Chase Bank.A. 17 ©2009 JPMorgan Chase & Co. All rights reserved. 9 Outsourced Provider – make sure that your outsourced provider has a view on all the upcoming recommendations and changes.Collateral management checklist 9 Tracking Developments – Are you participating in the relevant ISDA forums to keep up to date with collateral and reconciliation initiatives? 9 Wait and See – Some of the developments around CCPs. with different margin practices (around accruals and upfront margin). Some of the more immediate recommendations from ISDA are just that. 9 Technology and Operational Impact – The impact of the changes being discussed may mean more collateral accounts. ‘Futureproofing’ from potential changes is a key benefit of outsourcing. especially around buy-side participation and scope. .

N.A. All rights reserved. 2009 ©2009 JPMorgan Chase & Co. JPMorgan Chase Bank.Credit Derivatives Standardisation September 29. .

. All rights reserved.Big/Small Bang Protocols. applicable to new transactions only – standardized CDS • Changes to operations: existing responsibilities and procedures may need to be adapted (e. analysis. N. and European Corporates (SEC) • Further move to 100/500 fixed strikes for emerging markets.. Australia and New Zealand scheduled commenced on 21 Sep ‘09 • Asia (ex-Japan) and Japan trades expected to adopt 25/100/500 strikes commencing 21 Dec ’09 Benefits Benefits • To aid in the reduction of gross notional amount outstanding in the market – trades more easily compressed • To gain efficiencies in operational processing • ISDA Determination Committees as the authoritative source for credit and succession event decisions • To facilitate the implementation of CCP Impact Impact • Changes to CDS contract terms: applicable to full open population . build (if applicable) and implementation 19 ©2009 JPMorgan Chase & Co. restructuring event processing on CDS indices requires additional bookings). JPMorgan Chase Bank. Determination Committees activity requires monitoring • Change management: rollout of multiple initiatives throughout the year has meant that timeframes may be compressed for planning.A.g.Ongoing standardisation of credit derivatives Industry Industry Status Status / / Plans Plans • The ISDA ‘Big Bang’ Protocol in April‘09 introduced the auction supplement and ‘hardwired’ auction settlement for CDS contracts • The ISDA ‘Small Bang’ Protocol in July‘09 incrementally refined the auction process for a restructuring credit event • CDS single name standardisation already adopted for North American Corporates (SNAC).

Credit derivatives standardisation checklist 9Tracking Developments – Are you participating in the relevant ISDA forums to keep up to date with standardisation initiatives? 9Adherence – Did you adhere to the Big/Small Bang Protocols in April and July 2009? Did you check whether your counterparties have adhered? 9Operational Impact – Do you have the right tools to identify your trades impacted by specific events that Determination Committees opine on? 9System Impact – Can you differentiate between nonstandard and standard CDS? Do you need to enhance any of your messaging to external parties? 9Outsourced Provider – Is your provider ready to support the necessary changes: trade processing. All rights reserved. N. JPMorgan Chase Bank. settlements. confirmations? 9Residual Population – Are you trading any nonstandard CDS? 9Recouponing – Has your front office considered whether potential liquidity reduction might warrant recouponing of your legacy nonstandard trades? 20 ©2009 JPMorgan Chase & Co.A. . reporting.

Trade Reporting & Transparency September 29.A. . N. 2009 ©2009 JPMorgan Chase & Co. All rights reserved. JPMorgan Chase Bank.

but all market participants ‘strongly encouraged’ to comply within 60 days from implementation by the signatories to the letter • Asset class-aligned repositories (e. JPMorgan Chase Bank. with additional weekly ‘Copper’ trade upload • TriOptima selected as provider for the rates repository – 31 December 2009 deliverable • Industry RFP in progress for equity derivatives – vendor selection expected to complete by 31 October 2009 Benefits Benefits • Compliance with regulatory requirements for OTC position reporting • Increased market transparency Impact Impact • Focus on backloading of eligible credit derivatives to the DTCC TIW (target of 30 Nov 2009) • Potential need to upload non-TIW credit derivatives to DTCC ‘Copper’ reporting database • Requirements for rates and equity OTC reporting to follow once plans finalised 22 ©2009 JPMorgan Chase & Co. DTCC TIW for eligible credit derivatives).g..Trade reporting & transparency Industry Industry Status Status / / Plans Plans • Regulatory goal of full transparency of the OTC markets. All rights reserved. N. through implementation of a centralised reporting infrastructure • 2 June 2009 Fed letter — commitment to universal reporting of all trades not cleared through a CCP — phased deliveries by asset class through 2009/10 • Not yet mandatory for buy side.A. .

All rights reserved.For more information • Visit: www.com/visit/gds • Contact: – EMEA: Rob Wood +44-(0)207-777-0485 – United States: Darren Woolford at +1-212-552-0588 or Darren Measures at +1-212-623-5143 23 ©2009 JPMorgan Chase & Co.jpmorgan. JPMorgan Chase Bank.A. . N.